Indonesia’s Current-Account Gap Prompts a Rethink on Currency

Throughout the summer, as investors anticipating tighter monetary policy in the United States dumped emerging market assets, authorities in Jakarta fought a fierce rearguard action to defend the rupiah currency.

Bloomberg

A vendor receives rupiah from a customer at a market stall in Jakarta, Indonesia.

Even when other Asian currencies eventually rebounded, the rupiah stayed weak. Now it’s on a fresh downswing, dropping sharply in November to a fresh 4.5-year low around 12,000 to the dollar – possibly abetted, this time, by the central bank.

It’s not clear if Bank Indonesia Gov. Agus Martowardojo has read a November column by Olivier Blanchard, director of the International Monetary Fund’s research department, but he appears to be thinking along the same lines. Reflecting on a recent IMF conference, Mr. Blanchard wrote that for emerging markets “the evidence suggests the best way to deal with volatile capital flows is by letting the exchange rate absorb most…of the adjustment.”

Intervention in Jakarta is nothing new: During the summer’s taper turmoil the central bank drained nearly $12 billion from the country’s reserves to keep the rupiah from falling too sharply.

A spokesman for Bank Indonesia said BI has never intervened to weaken the rupiah. But Mr. Condon says the currency’s trading pattern for November — moving within a narrow trading range and usually closing far off the day’s high – differs from previous months.

“I see the hand of Bank Indonesia in that,” he says. “There’s no real good reason for the rupiah to depreciate 6% in November.”

Whether or not Bank Indonesia is really behind the rupiah weakness, it’s clear the summer selloff — which was hardest on countries running large current account deficits — led to soul-searching in Jakarta.

BI traditionally has managed monetary policy to meet an inflation target. At the November policy meeting, however, the bank said its surprise quarter-percentage point rate increase was aimed at improving the current-account balance.

“Our problem is the current account deficit, which needs to be fixed first,” Mr. Martowardojo told reporters after the meeting.

Fauzi Ichsan, senior economist and managing director at Standard Chartered Indonesia, says the change of heart began when Mr. Martowardojo became BI governor in May. He perceived that falling prices for commodity exports meant the current account deficit had become a structural feature of Indonesia’s economy, not some temporary or cyclical aberration.

A weaker rupiah helps Indonesia’s exports by making them cheaper on global markets; likewise, it cuts demand for imports by making them more expensive. Trade data Monday showed exports rose 2.6% on-year in October while imports fell 8.9%, producing a small but surprising trade surplus.

“Import compression is the key factor and is likely to remain so,” Credit Suisse economist Robert Prior-Wandesforde said in a research note.

At the same time, Bank Indonesia has raised its benchmark interest rate by three-quarters of a percentage point since the summer, and is likely to further raise it by an equal amount over the next six months, Mr. Ichsan said. That comes even as economic growth has slowed to its slowest pace in four years.

“If fundamentally the rupiah should be weaker, there’s no point in intervening in the currency market continually and depleting your FX reserves,” he said. “You allow the rupiah to depreciate, while raising rates to make sure it doesn’t tank too sharply.”

Of course, higher interest rates help on the current-account front as well by attracting foreign investment flows.

Mr. Ichsan predicts the rupiah will continue weakening — to about 12,500 to the dollar over the next six months – before gradually coming back to around 11,500. It was trading at 11,815 to the dollar late Tuesday.

The current account could take a bit longer to repair, perhaps as much as two years before it returns to surplus, he said.

The danger, Mr. Condon said, is if investors conclude Bank Indonesia is losing its focus.

”There’s a consistency problem. Bank Indonesia is an inflation-targeting central bank, and a weaker currency at some point would be inconsistent with an inflation target,” he said.

“I don’t think most people expect the next bout of taper turmoil to be as severe as the one last summer, but let’s say it is and this inconsistency has created doubt about authorities’ commitment to low and stable inflation – that’s the kind of thing that could add to selling pressure on Indonesian financial assets,” he said. “Bank Indonesia may get more than it wished for in terms of currency depreciation.”

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